Overview

At their monetary policy meeting in Frankfurt on 20/07/17 the European Central Bank’s (ECB) Governing Council announced that :

They would make no change to their key policy rates;

There would be no update of the ‘new’ guidance on interest rates, and;

The retention of the existing guidance on asset purchases (which has a bias to ease embedded within it).

We had expected President Draghi to be as dove-ish as possible in his tone, and we were not disappointed. He appears to have learned his lesson from Sintra – the tone on inflation was more downbeat today.

We had also anticipated that the Council would signal that an announcement on the pace of quantitative easing (QE) in 2018 was likely to come in September, but we were surprised on that front.

The timing of that (stealth) taper announcement is now fuzzy. The door has been left open to a September announcement but October now looks a little more likely because the Council has not yet tasked the staff committees to figure out how to ensure a continued smooth implementation of QE in 2018. We suspect that Draghi used the tightening in financial conditions in recent weeks to win a tactical victory within the Council today – delaying the countdown to the next stage of the stealth taper – but we still believe he has lost the war.

Exhibit 1: The ECB made no change to their key policy rates at the monetary policy meeting on 20/07/17 (the graph shows changes in the marginal lending rate and the deposit rate between 22/01/07 and 20/07/17)

Source: Bloomberg, BNP Paribas Asset Management as of 20/07/17

Unquestionably positive tone on the robust economic recovery

The Council continues to be encouraged by the ‘unquestionable improvement in the growth outlook in the euro area’. The tone of the Council’s Introductory Statement on the economic outlook remains positive:

“The incoming information confirms a continued strengthening of the economic expansion in the euro area, which has been broadening across sectors and regions”

and

“Incoming data, notably survey results, continue to point to solid, broad-based growth in the period ahead.”

Likewise, President Draghi noted that the survey indicators were near record highs and argued that the Council’s strategy had been ‘unquestionably successful on the real side of the economy’.

The reflationary forces didn’t come out to play today

For all the positivity on the growth outlook the message on the inflation outlook was – as expected – more downbeat. The Introductory Statement continues to stress the pass-through disconnect – the fact that good news on growth is not feeding through into inflation – and that ‘measures of underlying inflation remain low and have yet to show convincing signs of a pick-up, as domestic cost pressures, including wage growth, are still subdued’.

Despite Draghi’s protests to the contrary, the tone in today’s press conference on inflation felt decidedly less upbeat than in his remarks at Sintra, where he argued that:

“Now, we can be confident that our policy is working and that those risks have abated. The threat of deflation is gone and reflationary forces are at play.”

Instead, Draghi emphasised today that the bottom line of the Council’s discussion was that “Inflation is not where we want it to be and where it should be.” Indeed, Draghi was only willing to concede that the factors that are depressing inflation would probably not prove permanent.

Did someone mention patience and persistence?

The new ECB buzz words are confidence,patience and persistence: when you cannot credibly claim that you will take steps to ease the monetary stance the best you can do is to pledge that you will stick with the current stance for as long as possible.

The Council’s Introductory Statement continues to stress the need for “a very substantial degree of monetary accommodation.” When pressed President Draghi repeatedly fell back on the need for patience and persistence in monetary strategy (whilst taking confidence from the improving growth outlook and that the ECB will ultimately reach its inflation objective).

The problem of course is that we know that this patience and persistence language is going to be used to camouflage a taper as preserving the current stance. President Draghi reminded us at Sintra:

“as the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged.”

No announcement that an announcement is coming: don’t set dates!

The default approach to central bank communication these days – telegraph every breath you take, every move you make months in advance – suggested to us that the Council would signal at this meeting that they intend to make an announcement at an upcoming meeting about the pace of purchases in 2018.

We were wrong: there was no clear signal today. Indeed, President Draghi insisted that the Council had been unanimous in deciding not to set a precise date on when to discuss changes to the programme – we were left with the deliberate ambiguity of the statement that this discussion will take place in the autumn.

We did learn that the staff committees have not yet been tasked with looking at the options of what to do in 2018 – or more precisely what the Eurosystem buys in 2018 (in contrast, recall that in September 2016: ‘the Governing Council tasked the relevant committees to evaluate the options that ensure a smooth implementation of our purchase programme’).

On this basis, we are a lot less confident that a decision will be taken in September; October looks more likely now – although Draghi acknowledged the door has been left open to a September announcement.

To be fair, it’s probably more accurate to say that those Governors who are keen to press ahead with the taper refused to close the door on a September announcement.

Memo: Upcoming policy meetings of the Governing Council

Source: BNP Paribas Asset Management, as of 20/07/2017

QE easing bias retained

At the last policy meeting in early June it appeared that the Governing Council agreed that it was almost time to remove the ‘other’ easing bias in the Council’s forward guidance – the signal that the pace and duration of asset purchases could be increased in response to bad news.

However, the Council unanimously chose to retain that easing bias in the asset purchase programmes (APP) this month. Of course, cutting the duration aspect of that guidance on QE wouldn’t have made much sense when you are just about to announce an extension of QE into 2018 but the Council might have concluded that a pledge to increase the pace above €60 billion was no longer credible.

However, the Governors must surely have concluded that it would not be wise to pull the pledge to buy more bonds if financial conditions tighten immediately after a period where financial conditions have just tightened – although it may be that it took a lot of pressure from President Draghi to convince the Council around to this position.

Moreover, if the Council now feels that it needs to attach a similar pledge to the announcement on QE next year then it would seem perverse to withdraw the easing bias on 2017 QE only to re-insert it for 2018 QE.

Not (everyone is) unduly alarmed about financial conditions

President Draghi argued that the fact that the decision to retain the easing bias on QE was unanimous underscored the sensitivity of the Council’s strategy to financial conditions.

However, Draghi did not sound unduly concerned about financial conditions when he was first pressed on this issue: he stated that overall financial conditions remain “broadly supportive”, although he did highlight that the appreciation of the exchange rate had receive some attention in the discussions.

In our view, at this point Draghi was speaking for the Council as a whole – with many Governors willing to press on with a reduction in the pace of purchases given the current constellation of asset prices. However, later on in the press conference Draghi sounded more concerned about financial conditions – arguing that the last thing the Council needs is an unwanted tightening in financial conditions that may slow down or jeopardise the recovery in inflation – and here we think Draghi was speaking more for himself.

The lack of yield curve control

The fundamental problem for the ECB is that it lacks yield curve control. In a conventional QE set-up the central bank buys assets but the market still determines the price. The central bank can still influence prices by changing the pace of purchases or providing guidance about the future pace and duration of purchases. However, once the market has absorbed that information then prices are beyond the central bank’s control.

In contrast, the Bank of Japan effectively determines the price of long-term debt and therefore exerts a considerable influence on the currency and equity prices.

President Draghi may not like the fact that the nominal effective exchange rate has more or less reversed all the gains since the launch of QE and bond yields are rising too but if market expectations about ECB strategy are not out of line with the Governing Council’s intentions then there is very little to be done, unless the Council is willing to change its plan.

Draghi was pressed on this specific point but simply acknowledged that the nothing like yield curve control had been discussed by the Council, in which case the Council and markets should probably prepare for more bumps in the road ahead.

Failure to push back against rate hike expectations. Again.

Of course, there is one area where market prices are not in line with the Council’s forward guidance on its strategy – namely at the front end of the curve where the market has priced in modest hikes to the deposit rate over the next 18 months despite the fact that the Council continues to signal that it will taper QE first, then pause (interestingly the guidance still claims that rates will remain at their current levels ‘well past the horizon of the net asset purchases’) and only then raise interest rates.

We have been continually surprised by President Draghi’s half-hearted attempts to lean against those premature hike expectations and this was the ‘open goal’ in today’s meeting. If the Council wanted to ease financial condition this was the way to do it. President Draghi once again refused to grasp that opportunity.

Stage two of the stealth taper is coming.

The market reaction to Draghi’s Sintra speech appears to have sufficiently spooked enough members of the Governing Council to force a change of heart on strategy. We think that the Council will now adopt a more cautious approach to the exit strategy from QE and repeat the strategy pursued in December 2016 – that is, we expect a further reduction in the pace of purchases to be announced for a specific time frame with no internal debate or external communication over what happens after that which will allow President Draghi to claim that the ECB is not tapering its QE programme.

Last time around (in December 2016) we were surprised how many people were willing to go along with Draghi’s characterisation of ECB strategy. We doubt that the market will be so easily fooled this time around by the stealth taper. So long as the current issue limits remain intact then there is a limit to how many bonds the ECB can buy and that in turn implies that the programme must end at some point.

Flexibility and the capital key

Whenever President Draghi is challenged on how the ECB can continue QE in the face of mounting concerns over bond scarcity he dismisses the argument. For example, last month he replied that ‘the programme is running smoothly and as far as the future is concerned the programme has enough flexibility.’

Once again the flexibility of the programme was discussed. Of course, what he means is that there is flexibility within the programme to drift off the capital key – flexibility that is increasingly being exploited to manage the scarcity problem.

The share of French and Italian bonds within the overall flow of purchases has increased in recent months, whilst the share of Germany has started to slip back.

Looking ahead, that bias towards Italy is likely to build, but for obvious reasons it is difficult for President Draghi to be transparent about that. It may be that there is a limit to what some within the Council will tolerate when it comes to deviations from the capital key – particularly for so long as there is not a firm end date on QE – and that leads us to suspect that the corporate bond buying scheme (the CSPP) may also have to shoulder a large burden (a higher proportion of a smaller flow) in 2018.

Exhibit 2: The cumulative divergence from the ECB’s capital key buying targets shows the the flexibility within the programme to drift off the capital key is increasingly being exploited